Richard Green is a professor in the Sol Price School of Public Policy and the Marshall School of Business at the University of Southern California.
This blog will feature commentary on the current state of housing, commercial real estate, mortgage finance, and urban development around the world. It may also at times have ruminations about graduate business education.

Wednesday, May 20, 2009

Cap Rates and Commercial Real Estate Default

Commercial real estate mortgages are different from residential mortgages in a number of dimensions. One of the most important is term: while residential mortgages are generally self-amortizing, commercial mortgages usually have "bullets" or balloon payments arising from terms that are shorter than amortization schedules. For instance, a commercial mortgage might have a ten year term with a 40 year amortization schedule.

Many of these commercial loans are currently due or will soon be due. Many of them are performing well, in the sense that buildings, even after rent reductions, are producing sufficient cash flow to cover debt service. But because expectation have changed, capitalization rates have risen. This creates a problem.

Real Estate may be valued similarly the way stocks are values using the Gordon Growth Model. Income gets capitalized into value via a capitalization rate, which has two basic terms: a required rate of return, or discount rate, and an expected rental growth rate. The formula for valuation is simply V = Income/(r-g), where V is value, r is the discount rate and g is the expected growth rate.

Five years ago, a high quality office building would have a cap rate of 5.5 percent. The ten year treasury rate at the time was around four percent, so the 5.5 cap rate might have reflected that four percent rate plus a three percent risk premium less a 1.5 percent expected growth rate in rents (4+3-1.5).

Now, the ten year treasury rate is around 3 percent (actually 3.24 at this writing), which would tend to push down cap rates. but risk premia have widened, and rents are expected to fall. Suppose the risk premium is now 5 and rents are expected to fall one percent per year (they don't change that much from one year to the next because long term leases are in place). Now we get a cap rate of 3+5+1, or 9 percent. This would imply property values falling by (1-5.5/9), or a little less than 40 percent. This may overstate what is happening--as best as I can tell, values have fallen by about 1/3.

Consider a loan originated 5 years ago at a 5.5 percent cap rate and a 70 percent LTV. The loan to value ratio would have been conservative, and yet if the loan had no amortization (certainly a possibility), the building owner would be upside down, with a loan due greater than the value of the real estate. These are the properties that are extremely difficult to refinance, and may produce the next credit crisis.

Of course, had the mortgages been self-amortizing without a bullet, many of the loans would not have turned into problems.

I would respectfully disagree with Salesman of the Year. I would suggest that a 5.5% cap rate was absurd, just like the dot com bubble was absurd. With debt costs at 8%-10% for 70% LTV and GDP growth expected to be subdued for several years, a 9% cap rate may not be the bottom.

I think some of this could be adjusted or fixed with government loan guarantees to encourage banks to refinance with a lower assumed risk rate. It seems the only other option available would be the use of Chapter 11 of the Bankruptcy Code to force a modification of the loan into an amortizing loan based on value(if lower than balance) of the building rather then loan balance, but then to be paid at the market risk rate.

I must have had some bad breakfast, because I would also like to respectfully disagree with willie green. I think the government should stay away. Why force costs onto taxpayers. Further, I think the government is much less efficient and error prone than the private sector. There is plenty of money out there to clear the market. Let the bubble pop.

homebuyers are engaged in life cycle savings and consumption. Most of these borrowers probably want a loan that will amortize, as it accomodates their saving profile (I wonder how much of the problem with single family IOs and especially Neg Ams stems from the kind of borrowers who self-selected into these programs). Most multifamily borrowers are partnerships, coroporations, and other such fictional persons that attempt to stay fully leveraged at all times, and don't have any life cycle motivation to save. Since a lot of multifamily refi activity is expressly for equity take out (yield maintainance, etc. precluding interest rate reduction motivations by and large) by making these loans amortize you'd just make them churn and refi more often,

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As reported by AFX News Limited, besides banks and other financial institutions pension funds have been among the top investors in mortgage backed securities (MBS) and collateralized debt obligations (CDO). After years of channeling money into MBS and CDO portfolios of mortgages bundled and sold as debt securities the total size of pension fund securitizations are massive. Thomas Martin, president of the Homeowners Consumer Center estimates pension funds will take a 1 trillion dollar hit from devalued securities.

Your comments are right on - especially the last paragraph! You hit the nail on the head several months ago. These mortgages that are coming due are upside down. Trying to refinance a 70% loan today on a property that is worth 1/3 less. You can't get a 70% loan and the value is down so you will be writing a check at closing.

Federal bank regulators are close to issuing guidelines aimed at encouraging lenders to work out distressed commercial real estate loans. But how will this happen if there's no liquidity in the market?

Commercial lets normally have long lease contracts, with periods of 10 years and more not being uncommon. In addition to this, commercial property tenants are less likely to default on payments and even if the tenant goes into liquidation, the liquidator may continue paying the rent in order to stop the lease being forfeited.

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